MACQUARIE Gg tee ECON 632 Intermediate Microeconomics Week 11: Externalities and Public goods [Tirol ae e Externalities ° The inefficiency of competiti with externalities ¢ Allocating property rights to reduce externalities * Open-access common prope ¢ Public goodsMACQUARIE Externalities BP inca Externality — the direct effect of the actions of a person or firm on another person’s wellbeing or a firm’s production capability rather than an indirect effect through changes in prices: > Negative externalities harm others Example: a chemical plant pollutes and spoils a lake’s beauty and safety for recreational use by others. » Positive externalities help others Example: a teacher gets a flu shot and reduces his students’ probability of catching the flu.The Inefficiency of Competition Be wacouare with Externalities ° Consider a paper mill that produces paper in a way that pollutes the air and water. ° The firm’s private cost is the cost of production only (direct costs of labor, energy, and wood pulp), but not the indirect costs of the harm from pollution. * Intersection of private MC and market demand yields the competitive equilibrium. * The firm’s true social cost is the private cost plus the cost of harms from externalities. * Intersection of social MC and market demand yields the socially- brium.The Inefficiency of Competition MacQuARtE with Externalities Foe 450 Price of paper, p, § per ton - The competitive im, @,, excludes externalities and involves overproduction and DWL . - The social optimum, e,. - MCq is marginal cost of i ombest= WC Py = 282 |- eB 240 [rsessseseessetsressssssney 198 225 opts Q. Tons of paper per day p g 2 Social Optinium Private Change > $2 A As B+C+D B+C+D BsC4P+G F+G+H H-B-C Cc+G C+DsE+G+H D+E+H B+F P-C-D-E * }B-C-D-E PS,= PS, - Cy BS, + CS" Cy = Welfare, W = CS + PS, A+ B+F P A+ B+F-EOe St 5) Weffone incre by E =) E 3 te DwL ovet preclictor (at Gales WoW = dnl © Sol Ape eS ON Oke = 49 $0) =%™ 4¢Y ayqrnopur gov \ ou hi preemie é 043$= 7d Sol =< 1 IN =o pms . yw? Ofvas “wgrap prog em I } " | 4 ' 4 'MC = WC | cs = uc? ’ wet MC® =| MC = MCP D nce =D 2 pst pl ch tA dake > priveck preclue fir vba 4 1S efficiect a foe send peel. A IK the Same. To ucduce. DWL 2) provluchen Les a Socal pre Sy te uel ubere NC=D. woe MACQUARIE Reducing Externalities Fay The government might control pollution directly: ° by restricting the amount of pollution that firms may produce, for example: — EMISSIONS STANDARD (BUT POLLUTION CAN BE HARD TO MEASURE). ° by taxing firms for pollution they create; a governmental limit on the amount of air or water pollution, for example: — EMISSIONS FEE -TAX ON AIR POLLUTION = 2ottounel coxd—at the cocvelly — EFFLUENT CHARGE - TAX ON DISCHARGES INTO A RIVER. Opt are adpa. The government may impose costs on polluters by taxing their output or the amount of pollution produced. General principle: Internalise the externality — force the producer to bear the cost of the harm inflicted on others (or to capture the benefit provided to others).Taxes to Control Pollution. a MACQUARIE 'p University with fone *. equi: Money =D ® 2 = s g oe 450 = MCS = MC? +.(Q) & s & 3 8 p,=282 a MC? = 198 MC®9 = 84 <7 Copyright ©2014 Pearson Australia (a division of Pearson AY NES > WC Tax the firm’s output by just enough to equate private marginal cost with social marginal cost. Either an output tax equalling MCg ga (pivoted red line), or a specific tax of $84 per tone (dashed line). ae SS a dsl? aoe ve eerily 225 Q, Tonnes of paper per fay 2 $t 442522830/Perot/Mioeconoms/te A) we 8 = 198; ME= 262, DemandPractice question: FR Macquarie “—} University S$ P a) MC™= Dn wheel = NC™ = MC $II+ Q = 200-Q Qvt7Q = 200-Y AF 3Q = 120 DQ=40 McP = go+4o =]20 {ce a G0t 2x40 =[60 t uct s Pp fons MC-MC G = $40 0123/2017S0tQ = 200-N *) 2es IZOP c) Monopoly : MC = MR P= 200-Q ») mR = 200- 2Q fUt @ = 200 -—2Q ZQex120 3) QO =4O0= same aX stl opt od putAllocating Property Rights to Reduce Externalities MACQUARIE Uaheaaty * Property right — the exclusive privilege to use an asset. * Pollution results from ill-defined property rights * Coase Theorem — the optimal levels of pollution and output can result from bargaining between polluters and their victims if property rights are clearly defined.MACQUARIE Coase Theorem — Scenario PF ans Two firms: a chemical plant and a boat rental company, that share a small lake. The chemical plant dumps its wastes, which smell bad but are otherwise harmless, into the lake: the chemical company can reduce pollution only by restricting its output, it has no other outlet for this waste. The resulting pollution damages the boat rental firm’s business. There are other lakes nearby where people can rent boats, because they dislike the smell of the chemicals, people rent from this firm only if it charges a low enough price to compensate them fully for the smell.Gg MACQUARIE University Property Rights If the firms do not negotiate, the chemical firm produces the output level that maximises its profit, ignoring the effect on the boat rental firm. Ss McP oD If a court or the government grants the boat rental firm the property right to be free of pollution, the firm can prevent the chemical company from dumping at all. If there are no impediments to bargaining, assigning property rights results in the efficient outcome at which joint profits are maximised. Efficiency is achieved regardless of who receives the property rights. Who gets the property rights affects the income distribution. The property rights are valuable. The party with the property rights may be compensated by the other party.Be macouee Open-Access Common Property * Open-access common property — resources to which everyone has free access. Often referred to as ‘The tragedy of the commons’. * They have two characteristics: » rivalry —the quality or quantity decreases as it is used » non-exclusion — meaning that others cannot be prevented from consuming the good. ° Australian example: drovers’ tracks through remote regions.Public Goods BF racguare ° Public good — a commodity or service whose consumption by one person does not preclude others from also consuming it (i.e., no rivalry). * In general, public goods have two characteristics: » non-rivalry — [rivalry: only one person can consume the good] > non-exclusion — [exclusion: others can be prevented from consuming the good] * Apublic good produces a positive externality; excluding anyone from consuming a public good is inefficient.: : By macousee Rivalry and Exclusion Exclusion No Exclusion Rivalry | Private good: chocolate bar, Open-access common property: pencil, aluminium foil fishery, hunting, roads Public good: national defence, clean air, lighthour. No RivalryB MACQUARIE University Markets for Public Goods A public good is a special type of externality. Usually, if the government does not provide a public good, no one provides it. Markets undersupply public goods due to a lack of clearly defined property right. This problem is due to free riding. Usually, public goods only exist if there is an innovative way of fun good, e.g. free-to-air TV, which is paid for by advertisers. Because a public good lacks rivalry, many people can get pleasure from the same unit of output. As a consequence, the social demand curve, or willingness-to-pay curve, for a public good is the vertical sum of the demand curves of each individual. With increasing numbers of consumers the demand curve will be tend towards a vertica g theBw MACQUARIE University Demand for mall security guard services by two mall tenants: , Qa 4 =) toe stort valu toon QS fi —= at $3 shoe vere values Ee TV store velwx the ftemot $2 zt the racket value bo >) ford vale = $10, supoy, MC Conore prose” Bf by Hoe tq acc af ot gibt Sic Sal ‘te rv cep 0 Guards per hour i we boncy fo to nok Pt ee plogPublic Goods BF trcouare Society can rarely get individuals to contribute the optimal amounts toward a public good. * Many people free ride — benefit from the actions of others who pay for the pu good without paying for it themselves. Example: two stores deciding whether to hire a security guard ¢ First assume the stores act independently. (a) Stores Decide Independently Whether to Hire a Guard Television Store Hire Do Not Hire Hire al 8 Shoe Store SNGnt icra ETT Do Not Ee 0 Hire 8 0Bw MACQUARIE University Public Goods * Now assume the stores split the cost of a guard if one is hired. (b) Stores Voting to Hire a Guard Split the Cost Television Store Hire Do Not Hire Hire oa ef Shoe Store EEE | a || Do Not 2 | 0 ' Hire & | 0 In both games, the Nash equilibrium is for neither store to hire a guard because of free riding.